The IRS is watching you - Risk of Permanent Establishment

Israeli High Tech Companies Doing Business in the US
The IRS is watching you –
Risk of Permanent Establishment

A few days ago, the IRS released a practice unit to spot foreign companies with activities in the US, which are working through agents and/or a US subsidiary, named: “Creation of a Permanent Establishment (PE) through the Activities of a Dependent Agent in the United States.” (“IRS Guidance“). The IRS Guidance provides the IRS’ audit team a guide with respect to the creation of a permanent establishment (“PE“) for foreign companies in the US and provides a perspective of the IRS auditors on a certain type of questions, investigation, issues they are likely to review and information they will likely request.

One of the main goals of Israeli companies is to enter into the US market in order to sell, distribute products and develop the company’s US operations. Following their business plan, Israeli companies incorporate subsidiaries in the US (“US Subsidiary“), leasing space in the target state in the US, opening offices and transferring and relocating C level executives from the Israeli company (CEO, COO, CTO, etc.) to the US to work under the US Subsidiary payroll. As part of entering into the US market, an essential budget is allocated for the purpose of finding customers and potential business opportunities in the U.S.

Target accomplished! A U.S Subsidiary opens the market to the Israeli company in the U.S., through its senior executives who successfully presents the products, negotiates and concludes contracts with US customers.

However, what about taxes?

Transfer pricing is the first key issue that should be analyzed and reviewed prior to entering into the US market. Let’s assume that this matter was handled and the transfer pricing methodology between the US Subsidiary and the Israeli company is based on the net profit indicator under the Comparable Profits Method (“CPM“) (which means that the Israeli company paying its US Subsidiary an amount equals to the US subsidiary total costs in the US plus a certain amount which is a percentage from such expenses (i.e. “Cost Plus“)). As a result of this transfer pricing, most of the profits are recorded with the Israeli company and the US Subsidiary pays the IRS corporate tax on its limited profits, and based on that, the management of the Israeli company is under the assumption that no further claims of tax liability are owned to the IRS.

However, in the event that the IRS would come into conclusion that the operation of the US Subsidiary or the C Level employees is creating a PE of the Israeli company in the US than:

  1. The transfer pricing methodology would not assist in the allocation of major profit to the Israeli company, and the Israeli company would need to pay taxes on its profits to the IRS; and
  2. If the Israeli Company did not file with the IRS a “Protective Tax Return”[1], no deductions and/or tax credits would be allowed to the Israeli company in calculating its tax liability due to the IRS, and the Israeli company would need to pay US taxes on a gross basis instead of a net basis and in addition also penalties and interest.

The question is whether the Israeli company have a Permanent Establishment in the US?

Companies are quite aware that having offices or fixed place of business in the US might create a PE in the U.S, but less familiar with the risk of the classification of the US Subsidiary or agents as a “Dependent Agent” of the Israeli Company in the U.S. that would result in the Israeli company having a PE in the US.

In a nutshell, the term “Dependent Agent” in the tax treaty between Israel and the US provides that: “..A person acting in one of the Contracting States on behalf of a resident of the other Contracting State, other than an agent of an independent status to whom paragraph (6) applies, shall be deemed to constitute a permanent establishment in the first-mentioned Contracting State if such a person has, and habitually exercises in the first-mentioned Contracting State, an authority to conclude contracts in the name of that resident, unless the exercise of such authority is limited to the purchase of goods or merchandise for that resident”.

As can be inferred from the definition under the treaty, a person (individual or a company) that falls under the purview of the definition, would create a PE in the other contracting country. On the other hand, if such person is an agent with an independent status and is acting in the ordinary course of his business, its activities would not result in PE.

The IRS Guidance discusses a UK parent company that runs an international hotel business through owned and franchised hotels. The UK Company holds a U.S. corporation which owns and operates U.S. hotels. The US subsidiary negotiates franchise contracts on behalf of UK company with various U.S. hotels. The IRS Guidance provides certain key issues and factors to the tax assessing officers to spot situation of the existence of a PE through such international operations in the US. The IRS Guidance requires to check certain criteria: Are the contracts concluded by US Corporation related to its parent essential business operations? Does the US Corporation habitually exercise its authority to conclude contracts on behalf of UK company? Are the contracts concluded by US Corporation binding on UK Parent? and last question and issue, is the US corporation a dependent agent of the UK company? It should be noted, that the issues and review should be examined based on that certain conditions set forth in the relevant tax treaty with the US, however in most cases the wording in treaties with respect to PE are similar, and additionally, the IRS Guidance provides us certain highlights to do or not to do in relation with Dependent Agent status.

Issue 1: As discussed, a foreign enterprise has a U.S. PE through a dependent agent if the agent habitually exercises its authority to conclude relevant contracts that are binding on the enterprise.

  • Key Factor 1: Whether or not such a condition is met should be determined based on the commercial realities under the situation.
  • Key Factor 2: The extent and frequency of the activity necessary to conclude that the agent is “habitually exercising” contracting authority, will depend on the nature of the contracts and the business of the Israeli company. An agent shall be considered as regularly to exercise authority to negotiate and conclude contracts or regularly to fill orders on behalf of his foreign principal, only if the authority is exercised, or the orders are filled, with some frequency over a continuous period.

THEREFORE, an agent shall not be considered as regularly negotiating and concluding contracts on behalf of his foreign principal if the agent’s authority to negotiate and conclude contracts is limited only to unusual cases or such authority must be separately secured by the agent from his principal with respect to each transaction effected.

KEEP Records and Analyze as for how many contracts did the US Corporation enter into on behalf of Israeli Company as compared to other Israeli Company’s agents entering into contracts in other countries? – How many contracts did the US Corporation enter into compared to prior years?

Issue 2: Only agents, having the authority to conclude contracts, can lead to a PE for the foreign enterprise maintaining them. In such a case, the agent must have sufficient authority to bind the foreign enterprise’s participation in business activity in the United States.

  • Key Factor 1: facts and circumstances basis: An agent who is authorized to negotiate all elements and details of a contract in a way binding on the foreign enterprise is considered as having the authority to conclude contracts on behalf of the Israeli company.
  • Key Factor 2: Does an Israeli company need to have final approval of the US Company contracts? Does the Israeli Company exercise its authority of the final approval (e.g., does it ever amend or cancel contracts entered into by US Corporation)?

THEREFORE, the test is based on substance over form. Note, even if the contract is signed by another person or if the agent has not formally been given a power of representation, but the other person’s responsibilities are merely ministerial, the US Corporation shall be treated as having the authority to conclude contracts.


Few factors that are indicating dependency:

  1. Significant Control. An independent agent will typically be responsible for his foreign principal for the results of his work but not subject to significant control with respect to the manner in which that work is carried out. The agent will not be subject to detailed instructions from the principal as to the conduct of the work. The fact that the foreign enterprise relies on the special skill and knowledge of the agent is an indication of independence.
  2. Agent does not Bear Business Risk. Whether a person is economically independent of the foreign enterprise represented depends on the extent of the obligations which this person has versus the enterprise. An important criterion is whether the business risk is borne by the person or by the foreign enterprise the person represents. Business risk refers primarily to the risk of loss. An independent agent typically bears risk of loss from its activities. In the absence of other factors that would establish dependence, an agent that shares business risk with the foreign enterprise, or has its own business risk, is economically independent because its business activities are not integrated with those of the foreign principal. Conversely, an agent that bears little or no risk from the activities it performs is not economically independent.
  3. Profits. If the agent is required to generate business to earn a profit, this indicates that the agent bears business risk. If the agent is able to secure contracts solely due to its relationship with the principal, this indicates that the agent does not bear business risk. If the agent earns a significant portion of the income generated by the contracts, this indicates that the agent bears business risk. If the agent bears the cost of failed contracts or sales, this indicates that the agent bears business risk.
  4. Exclusivity. An exclusive or nearly exclusive relationship with the foreign principal may indicate that the foreign principal has economic control over the agent due to the limited scope of the agent’s activities and the agent’s dependence on a single source of income. However, an agent may be economically independent notwithstanding an exclusive relationship with the foreign principal if it has the capacity to diversify and acquire other clients without substantial modifications to its current business and without substantial harm to its business profits. An agent’s agreement not to sell competing products, not to enter into contracts with others or not to take a financial interest in a competitor of the foreign principal may indicate that the agent is dependent. The control which a parent company exercises over its subsidiary in its capacity as a shareholder is not relevant in consideration of the dependence or otherwise of the subsidiary in its capacity as an agent for the parent.

Summary. As can be inferred from the above, an Israeli company could be viewed as having a PE in the US by virtue of its US Subsidiary or any person located in the U.S. Such situation can occur if the US Subsidiary or any person would be treated as “Dependent Agent” of the Israeli Company. Relocating C level executives from the Israeli Company to the US to work through a US Subsidiary or otherwise, should carefully be reviewed as their operations solely may trigger a PE in the US.

When operating in the US through a US Subsidiary, special attention should be made as for control, instructions by Israeli Company, terms of intercompany agreement, authorly of the US corporation, its employees, officers, stages in negotiations, approval procedures of agreements, skill and knowledge, review risks of each company, transfer pricing, filings and more. Most important when having doubts as if US corporation or any person is independent or dependent agent of the Israeli company, make an internal tax analyzation as if Israeli Company needs to file “protective tax returns” in the US to reduce the tax liability, in case that the IRS would come into conclusion that the Israeli Company has a PE in the US.

For further information, you are welcome to contact Adv. Oren Biran, Partner and Head of the GKH Tax Department, at +972-3-607-4547 or via email: and/or other advocates from the Tax Department of Gross, Kleinhendler, Hodak, Halevy, Greenberg, Shenhav & Co. (GKH).

This communication is for general informational purposes. It is not intended to constitute legal advice or a recommended course of action in any given situation. This communication is not intended to be, and should not be, relied upon by the recipient in making a decision of a legal nature with respect to the issues discussed herein. This communication does not create an attorney-client relationship between Gross, Kleinhendler, Hodak, Halevy, Greenberg, Shenhav & Co. (GKH) and the recipient.
Gross, Kleinhendler, Hodak, Halevy, Greenberg, Shenhav & Co. (GKH), is one of the leading law firms in Israel, with over 170 attorneys. GKH specializes, both in Israel and abroad, in various fields of law including Tax, Mergers and Acquisitions, Capital Markets, Technology, Banking, Project Finance, Litigation, Antitrust, Energy and Infrastructure, Environmental Law, Real Estate, Intellectual Property and Labor Law.


  1. Foreign corporations that determine they do not have a US PE in the U.S. under an applicable income tax treaty should consider filing a protective return.  In this case, such foreign corporation are generally required to file a Treaty Based Return Position (Form 8833) with Form 1120-F to assert the treaty exemption claim.  Timely filing a protective return preserves the foreign corporation’s right to offset income with allowable deductions and credit, should the IRS subsequently assert the company does have a taxable US PE.

Oren Biran

Phone +972-3-6074547

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